Definitions in factor investing matter

Factor investing has experienced a significant increase in popularity in recent years as institutional investors continue to look for better ways to build portfolios.

But not all managers defined the same factors in a similar way and that could have a large impact on the end result, according to Towers Watson.

“When you are looking whether a factor makes sense in your portfolio, you really want to be sure that that factor is real and robust,” Towers Watson investment consultant Jessica Melville told theinstoreport.

“We find that certain factors in Australia are quite susceptible to different definitions.

“In value, for example, whether you define it as price-to-book or cash-flow-to-price or PE (price-earnings ratio), you can end up with very different return profiles and very different sector exposures.

“So what kind of diversification benefits it brings to your portfolio is going to vary depending on how you are going to define it.”

The popularity of factor investing stems from the idea factors are less correlated with each other than assets and could provide a greater opportunity for diversification.

But to achieve optimal diversification benefits, investors need to pay close attention to how factor strategies are implemented.

“The take-up [of factor strategies] is definitely on the increase and certainly we start to see a lot more focus on using it in domestic equities,” Melville said.

“The use in global equities was certainly there already, but the Australian market is a lot narrower and there is a lot more noise in terms of implementing it, so it is a tricky conversation to have.

“Some of the factors don’t really work [here].”

The small companies factor is an example of a factor that has been studied extensively and has found application globally, but Australian investors tend to favour large companies that pay out sizeable dividends, which means this factor is less clear in domestic markets.

“It is an interesting one because the small size is so well documented, in the US particularly, and it works in global equities as well,” Melville said.